The pluripotency of cash: a deconstruction of a U.S. hospital's financial state

Our case and data pertain to a community hospital in the United States. Data comes from an article in the local newspaper. The hospital is threatened with a full corporate takeover because of poor operating margins, "financial  free fall", and hospital admin not having "a plan or strategy to stem or reverse the operating losses and revitalize its business". Ignoring the hyperbole, let's look at the numbers reported and understand what could be the source(s) of ire.

The article reports the folllowing financial information:

• liquid assets dropped by $40 million - representing a 51% drop in the last 9 months

• by the end of the year, liquid assets will fall to $5 million

• $62 million in public bonds (debt) and $40 million in pension (debt)

• A private equity firm invested $42 million into the hospital 5-6 years ago.

Below shows the trajectory of the liquid assets in the current year - it's a straight line down. Why would liquid assets fall rapidly within one year? What are the fates of a liquid asset and which fate would upset the private equity firm?

Source: Ramm M. Texas investment company files to take over financially troubled Iowa City hospital. Des Moines Register. 24 July 2023.

Disclaimer

This exposition is serves an educational purpose only. I have no idea what the hospital leadership or private equity holder is thinking and I don't presume to know. I'm not passing praise or prejudice to or against any party involved in this case or mentioned in the source article. If you, as a reader, have a pre-conceived positive or negative opinion of either party and are looking for validation of that opinion by reading this exposition, you're in for a disappointment. In a similar light, if you, as a reader, want to know my opinion on these stakeholders, you're also in for a disappointment. MedFin Ventures is all about facts and figures.

Assets

Assets are resources that businesses use to operate and generate revenue. They come in many forms: current and non-current, liquid and non-liquid, fixed and other.  In our case, the focus is on liquid assets - those assets that can be easily converted or used for something else. The most liquid of them all is cash - thus we will work on the premise that the cash assets is falling and alerting private equity of a problem.

What happens to any asset (liquid or otherwise)? For a non-investing company, like this hospital or a healthcare-focused business, assets are meant to be consumed. Their acquisition, and therefore their consumption, should facilitate the operations of the business. When consumed, an asset should generate operating revenue.  Most assets can't be used in-perpetuity.  They depreciate in value over time (time-decay) and with repeated use (consumption to generate operating revenue).

The uniqueness of the cash asset

Cash is a unique asset. Indeed cash will depreciate over time, just like any other asset. The depreciation of cash is not a result of consumption, however, but a lack of consumption/use. Compare cash to a fixed asset, like a CT scanner. The CT scanner will depreciate over time as the hospital uses it. Time-decay will also erode the value of the CT scanner, as newer models come to the market and newer technology replaces what the hospital is currently using. Both consumption and time can erode the value of the CT scanner, but only one can be modified by the hospital to reduce the rate of depreciation: consumption. If the hospital uses less and less of the CT scanner, its rate of depreciation can slow.

However, if the hospital (or your healthcare business) consumes less and less of cash, the rate of depreciation increases.  Why? Cash, unlike any other asset, is sensitive to the external economic environment - namely, inflation. Inflation drives the depreciation of free cash, whereas it (inflation) can appreciate the value of a fixed asset.

All of this is meant to convey the importance of a business using (rather than sitting on) its cash assets for its operations.

The pluripotency of the cash asset

Cash is not a terminally differentiated asset - it is pluripotent. It can be used for many things...but it has to be used. Let's look at some of the use-cases for cash and predict how two stakeholders, the firm and its equity holders, would view each case.

Use-case #1: acquire an asset

Cash is often used to purchase another, less liquid asset. In our case, the hospital may have been using its cash (see graph above) to acquire new resources for its operations. Some reasonable examples include: new imaging equipment, expanding the clinical square footage of the Emergency Department or developing an Urgent Care, increasing inventory of critical medications, purchasing ECMO/CRRT/LVADs or other devices, and so on. One could imagine how the acquisition of some of these assets could precipitously drop the cash balance within one calendar year. Presumably, these acquisitions are strategic and quantitatively predicted to increase operating revenue and gross profit margins. In other words, the hospital would:

use cash to acquire an asset needed to service patient-customers which results in more operating revenue and a higher gross profit margin

The article doesn't give us enough information to deduce the likelihood of this particular use-case, but it is a reasonable use of cash. Some equity holders, however, may have a different view. They may not consider the acquisitions as smart business decisions that will increase operating revenue. In that case, they'd oppose using cash to purchase assets that would result in a lower profit margin. A loss can be predicted if the extra capacity gained through the purchase is superfluous - for example, acquiring a 3rd CT scanner when the first 2 are already under-utilized. If cash has to be used (see above) and purchasing a particular asset isn't a good use for it, then returning it (cash)  back to the equity holders (a dividend) would be preferred (more on that down below).

Use-case #2: reduce liabilities

Cash can be used to reduce liabilities and improve a business' solvency. In our case, the hospital has, at the minimum, $102 mil in liabilities - divided into bond payments and pension obligations. There are certainly more liabilities in the form of unpaid labor and property lease expenses, as well as unpaid maintenance costs. Depending on the cost of capital (i.e., the cost of borrowing money or the amount of equity needed to be sold to raise capital), a business may choose to borrow capital (at a lower interest rate than that which is placed on their existing debt obligations) or sell more equity shares to reduce its debt burden. An easier way, however, to reduce debt burden is to use a firm's cash balance - a move that does not trade a higher-cost debt obligation for a lower-cost one and does not dilute existing equity of all shareholders.

An equity holder can take two views on using cash to reduce liabilities, depending on the type of liability being reduced. 

1. As a residual claimant, equity holders have to *wait in line* to be compensated if a firm becomes insolvent. Primary claimants are those who own the debt - they are recompensed first, ahead of the equity holders. If a firm chooses to use its cash position to lower this type of liability, it reduces how *deep in the line* the equity holders are. Equity holders can only become primary claimants if the existing primary claimants (debt holders) are all paid first.

2. If the firm chooses to use its cash to pay operating expenses, such as labor, lease, maintenance, utilities, suppliers, the equity holders remain in the same residual claimancy position as before. That's because the debt holders have not been fully compensated. Using a firm's cash asset to meet its working capital requirements (WCR) indicates that the business operation isn't generating enough cash itself. The existing non-liquid assets, which were acquired by the business to generate operating revenue, aren't generating enough revenue to meet the costs of the business. Based on the source article for our case, it is possible and probable the hospital's operating revenue isn't meeting the expenses incurred. Since those expenses are likely current liabilities (have to be paid this year - cannot be postponed), they must be paid through cash. Equity holders would rightfully be concerned about the solvency of such a firm.

Use-case #3: invest the cash

There are times when a business is doing well and doesn't need to purchase a new asset or reduce its liabilities any more than its current rate. When this event happens, a business won't consume its cash asset for operating the business. However, it can't let the capital sit in the cash account - the cash will depreciate because of inflation. So it decides to loan its cash or purchase an equity position to another entity - i.e., it decides to make an investment.

Those investments will, hopefully, provide a return that will appear on the income statement as *investment revenue". Some equity holders may be satisfied with this tactic, but remember that non-investing-focused firms, like the hospital, aren't in the business of investing. Equity holders may not have confidence in the ability of a non-investing-focused business to make the best investing decision. They (equity holders) would rather make investment decisions for themselves, and may demand that the business provide a return on their equity so that they can make those decisions if they so choose. 

Use-case #4: provide a return to the equity holders

If a company doesn't have a good reason to use its cash - in other words, it can't find a pathway in which it uses its cash to boost operating revenue - it should consider returning that cash to the equity holders. That return is the dividend. Equity holders really like dividends; if for no other reason than it gives them back control over their earnings. They can do what they wish with dividend - reinvest back into the original company (buy more equity), invest elsewhere, or use the cash for a non-business reason (e.g., vacation, new car). It's highly unlikely that the hospital in our case returned cash back to the equity holders.

So what do I think has happened? Just like you, I can take a guess based on what has happened in the past between other hospitals and private equity firms. However, I don't have enough information from the source article or other sources to comment on the details or nuances of this case. More importantly, when you run your own healthcare-focused venture, you'll need to keep an eye on your cash asset and determine how best to employ it. You have options, each with its own (dis)advantages that give you flexibility depending on what your venture needs are at the time.